6 Reasons a Recession Might Be Coming

January 22, 2016 by Trey Thoelcke

We are now seven years away from the last major recession. Considering that buffer, it is hardly controversial to suggest that we are closer to the next recession than we are to the last, but are we closer than we think? Here are six reasons why we could be just around the corner from a downturn, if it hasn’t already begun.

China

Start with the most obvious, China just reported “only” 6.9% growth for 2015, but the Chinese government has a sordid history of inflating economic figures going all the way back to the late 1950s. In other words, China’s GDP deflator is probably quite high. Chinese equity markets lost more than 40% value during the closing six months of 2015, and the few pieces of data we get suggest that fundamentals underlying the Chinese economy are indeed collapsing.

The headline figure at the moment is rail freight data that showed a 10.5% year-over-year decline. As Chinese demand for international exports shrinks, the bottom lines of the companies that support this demand will also. Major industry in the United States, Germany, Australia and Japan rely heavily on revenues generated through exports to China, and it won’t take too much of a dip in these exports to cause industrial contraction, downsizing, increased unemployment and so on.


The Federal Reserve

In December the Federal Reserve finally raised the U.S. federal funds target rate. This is an action generally taken by the central bank of a strong, robust economy with moderate inflation. While superficial data suggests strength, including low unemployment and a booming real estate market, things may not be what they seem. Inflation is almost nonexistent, and despite the collapse in oil prices, consumer spending is flat. Real estate prices are at more than a four-times multiple of median household income. Mortgage approvals are up, meaning buyers are paying over the odds for property they wouldn’t be able to afford at higher interest rates. This sounds a little too familiar.

But the real problem is the Federal Reserve’s lack of tools with which to tackle a downturn if and when it comes. With rates already extremely low and having just come out of a huge asset purchase program, the Fed is effectively redundant in its ability to counter a recession, meaning when things fall, they could fall hard and fast.

Europe

Europe has never fully recovered from the last recession. Despite aggressive quantitative easing and negative rates in some countries, much of Europe is still suffering from high unemployment, little to no economic growth and weak consumer sentiment. Without Germany, Europe would have plunged into recession a long time ago, and it now looks as though even Germany is faltering, and the massive Syrian refugee crisis is not helping.

Germany is heavily reliant on its exports to China, and as these exports dry up, Germany’s ability to support the rest of Europe will decline. There’s a long way to go before Europe strengthens, and it could involve a host of unprecedented monetary maneuvers from the European Central Bank. The efficacy of these maneuvers may only determine the depth of the next recession, rather than whether or not it arrives.

Oil

This one seems counterintuitive at first glance because low oil generally stimulates an economy, as it frees up capital for alternative allocation both on a consumer and an industry level. This may prove the case, longer term. Short to medium, however, a wave of debt defaults are nigh in the oil sector, and that may have systemic consequences. The U.S. financial sector is highly exposed to the energy sector. U.S. banks have leveraged loans for the energy space of nearly $300 billion, and 15% are now considered distressed and rising.

On a more micro level, the energy sector accounts for a little over 1.2% of total U.S. employment, and in the wake of price collapses, firms are cutting as much as 15,000 jobs a month. The same is true in other developed economies, with energy employing 1.4% in Germany and just shy of 1% in the United Kingdom. Oil may well be what drives a recovery longer term, but under current conditions, it could just as easily be the architect of a decline.


Inventories

This one doesn’t get much press, but that doesn’t mean it isn’t a major factor. Every month the U.S. Census Bureau reports the retail trade inventory to sales ratio. The latest available figure showed a ratio of 1.48 for November, a level not seen since 2009. Why does this matter? Because it means that inventories in the retail sector are at their highest levels in over six years. When inventories are high, retailers try to reduce inventories. During destocking periods, retailers don’t order fresh supply, and this puts pressure on the bottom lines of the companies that rely on front line retail for their orders. This pressure could quickly translate to layoffs and the downward spiral that succeeds a rise in unemployment.

Political and Military Instability

It’s election year in the United States, and we generally see a boost in the equities market on the back of a new president elect. This year, however, wider political instability might mute that boost. The raising of sanctions on Iran has U.S. and global sentiment divided. Russia is in the midst of spearheading its own Middle East wars that look like they are heating up. Saudi Arabia and Iran are trading barbs now. Greece remains on the brink of collapse despite other events grabbing headlines, and it could still default and leave the eurozone. All these things could spark a switch to risk off sentiment and a recession.